5/01/2006 @ 6:46AM

Oil Companies Won't Fish

As Americans start hitting the open road this summer and high gas prices creep even higher, the oil industry will draw an increasing amount of fire from critics who claim it should be doing more to increase supply. Already, President George W. Bush, himself a former oilman, has lamented that the oil companies aren’t investing more to expand production.

With the price of crude well above $70 a barrel, the oil companies have all the incentive they need to scour the world for new reserves and ramp up more costly production of unconventional oil. The notion that Big Oil is constraining supply in order to reap outsized profits is the stuff of conspiracy theory: Private oil companies have no more control over the world price of oil than motorists.

So it is puzzling to many industry analysts that instead of using these profits to develop new sources of supply, they prefer to lavish them on their shareholders in the form of higher dividends and buy back stock. The industry protests that it has poured $106 billion into new production already this year. But though that may sound like a lot, it isn’t even enough to replace the depletion of current oil fields as well as cover the wear and tear on equipment and machinery.

“The oil companies have done a tremendous amount of investment,” says James Hamilton, an economist and energy expert at the University of California at San Diego. “But they have to just to remain in the same place.”

Several factors are making it difficult for the companies to expand production, including shortages of engineers and equipment created from years of low-priced oil. In addition, investment opportunities are scarce. Up to 75% of the world’s reserves are off-limits to private oil companies, calculates Philip Verleger, an industry expert at the Institute for International Economics in Washington. And the projects that are available aren’t always that lucrative since national governments demand most of the profits for themselves.

But another, more surprising, factor is holding back the oil companies: They simply aren’t that bullish on the oil market 10 or so years down the road, when a project started today will start to produce oil.

“My guess is virtually 90% of the oil industry is assuming that $70 oil is not going to last more than a few years,” according to Adam Sieminski, the chief energy economist at
Deutsche Bank
. He guesses that most oil companies are projecting crude will fetch $40 a barrel plus inflation over the long-term.

On that score, the oil companies appear to be virtually alone. Wall Street continues churning out predictions of $100 oil. Hedge fund managers are pouring millions into oil futures. And peak oil theorists, who argue that humans have produced nearly half the oil that there is to produce, and that therefore prices will shoot up enough to bring economic growth to a halt, are enjoying their heyday.

“The people most alarmed about future supply are not the people running oil companies,” says John Felmy, the chief economist at the American Petroleum Institute, an industry trade group in Washington.

The oil companies haven’t forgotten the 1986 bust that wiped out nearly half the industry. Today, they worry that a slowdown in the global economy or a flood of new supply could bring prices crashing down. The former happened in 1998, when the Asian financial crisis produced the lowest-price oil in inflation adjusted terms.

And if oil expert Daniel Yergin is right, the world is about to see an unprecedented surge in supply. A field-by-field analysis conducted by his company, Cambridge Energy Research Associates, predicts that 16 million new barrels a day will come online by 2010. That would amount to a 20% increase in world oil production.

At the time of the study’s release last summer, critics charged that it low-balled the rate of depletion for fields currently in production and that it didn’t leave room for the inevitable slippage of project deadlines. To some extent, they were right. Production in the North Sea has declined more rapidly than Cambridge Energy predicted, and Gulf hurricanes have knocked some projects off course. But there is little doubt that a good portion of this fresh supply will come online eventually as the projects were planned when oil was much cheaper.

Over the longer term, oil companies are counting on getting cleverer at extracting more oil from any given field as well as from unconventional sources, such as oil shale or tar sands. If history is any guide, they will succeed.

In the past, only 10% of oil discovered worldwide ever made it to market, says Jerry Taylor, the director of natural resource studies at the Cato Institute in Washington. But thanks to the march of technology, that portion has climbed to 35%; a move to 40% would create a big increase in new supply. Peak oil theorists have ignored the impact of these technological advances when they have predicted for years that world oil production was nearing its peak. And that is the reason they keep getting it wrong.